High-yield debt well positioned for the downturn

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High-yield debt is in a much better position to weather a recession than in previous economic downturns, according to T. Rowe Price.

Besides the pandemic-induced recession in 2020, Mike Della Vedova, co-manager of T. Rowe Price’s global high-income bond strategy, noted that most other strategies were credit-focused. In other words, they were caused by concerns about the solvency of certain assets.

“The financial crisis and the dotcom meltdown, for example, were primarily caused by the accumulation of debt-related excesses in the US housing sector and internet infrastructure, respectively,” Della Vedova said.

However, if the current slowdown turns into a recession, he said inflation would be the main cause.

“Inflation-induced recessions are rare, the last one occurred between 1982 and 1983,” Della Vedova said. “There is a risk of having one now due to the colossal amount of fiscal and monetary stimulus injected into the global economy in recent years, first after the financial crisis and then during the pandemic crisis.

“This liquidity inflated asset prices and fueled speculation, leading to the inflation spike we see today,” he added.

For Della Vedova, whether a recession is credit-related or inflation-related is an important distinction.

“Historically, the damage to corporate earnings tends to be more modest during inflation-related recessions,” he argued.

The fact that corporate balance sheets have strengthened since 2020 also supports the case for high-yield bonds, added Stephen Marsh, portfolio specialist at T. Rowe Price.

“Only 1% of US and European high-yield corporate debt will mature this year, with a relatively small amount of debt maturing in 2023,” he said. “The bulk of the ‘maturity walls’ of high-yield issuers will arrive in 2025 or later, indicating that balance sheets are strong.”

A third pillar of support for the asset class is that it has just gone through what Marsh described as a “brutal” default cycle, but which has left the sector in a much better state of health.

“In 2020, default rates among high-yielding U.S. energy companies reached nearly 30%, while debt restructurings surged among European retail companies,” he said. “The default cycles, however, are useful in separating the strongest companies from the weakest.

“Those with the potential to survive and thrive beyond a crisis tend to be well supported by their sponsor investors, who inject cash when needed or provide lines of credit in order to realize their investment later,” he added. “Companies that have little prospect of long-term success are generally allowed to fail.”

While valuations imply corporate debt defaults will rise in 2023, Marsh does not believe this is a realistic assessment.

“The current US and European high yield default rates are 0.36% and 0.01%, respectively,” he said.

“These ultra-low levels are unsustainable in an environment of slowing growth and high inflation, so defaults will inevitably increase.

“Indeed, current market valuations imply a global high yield default rate of 3.9% over the next 12 months (assuming a 350 basis point excess spread),” he added. “However, we believe that market valuations are partly driven by general macroeconomic concerns and that the actual default rate should decline.

For these three reasons – namely an inflation-fueled recession, improved balance sheets and the recent exit from a default cycle – Della Vedova concluded that high-yield debt is now in a much better position to weather a recession than in the past.

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